(GuruFocus, March 9, 2010) This much we have a consensus: The current bull market was officially born on March 9, 2009 and market has rallied about 70% since then. What we do not know and we cannot agree on whether we are in a secular bull market or a bear market rally.
That is the topic of debate between Robert Shiller of Yale University, Jeremy Siegel of University of Pennsylvania’s Wharton School, and Ben Inker of GMO LLC, as it is written up in today’s Wall Street Journal. Shiller and Siegel became friends since their student years in MIT in the 1970s, yet they disagree on which way the market is going.
Shiller, author of famous book Irrational Exuberance in which he warned of the tech bubble before it burst in 2000, is on the bearish side. His reasons, according to the WSJ:
Siegel, also author of a well-read book called “Stocks for the Long Run” is on the bullish side. He contends that Shiller’s method of looking at earnings of the past 10 years doesn’t work well in the current environment due to the large write-offs of the financials in 2008. Instead, he prefers to use the forecasted earning:
Ben Inker, in consistence of the firm’s stance on the matter, presented his arguments from a different angle – he uses historical profit margins to forecast future corporate profits. His reasoning:
Of course, true value investors will consider guessing the short-term move of the market is a fool’s game. Whether the market will climb 20% or decline 20% next is really everybody’s guess. Guessing the long-term’s performance might be a fool’s game too, if it is up to guys like Warren Buffett, Bruce Berkowitz, and Donald Yacktman to say. For them, one ought to buy a good business on the assumption that no matter how the market will performance in the next couple of years, the business will do well so will the stock follow.
But at least one can answer question of long term expected investment return of the market with a bit more intelligence.
What to Expect in the Next 8 Years?
GuruFocus has developed a webpage dedicated to answer that question. The theory behind (it is actually explained on the webpage itself, I repeat here in case you do not want to click to another page) is that market return consists of three component: dividend yield, profit growth, and change in market valuation. Quoting from the page:
As of now, we should expect an average gain of 5.7% for the next 8 years if the market ends the 8-year period at TMC/GDP=80%. Yes, it is mediocre gain as compared to the historical average gain, but it does beat the 10-year treasury yield by about 2%.
Market could sink an average of 2.6% per year if TMC/GD ratio declines to 40%, an extreme level seen in the 1975 to 1985 period. During that period, OPEC was on our case and inflation ran as high as 12%, and long term treasury bonds were yielding at a double digit. Will we go there?
However, if the market participants decides to irrationally exuberant again and TMC/GDP jumps to a 120%, level seen in the 1998-2000 period, we could actually expect a 11.6% gain per annum. What medicine do we need to take in order for us to be so happy again?
So even in long run anything is possible -- if the market goes to the extremes in the next 8 years, the bears like Shiller and Inker could be right, so could be the bullish Jeremy Siegel. Investors are better equipped to know what to expect under each scenario. GuruFocus memebers can access the Broad Market Valuation in real time.
"That's why the value of expertise and the ability to interpret information will someday go to infinity", so says Investment Guru Wilbur Ross recently.
That is the topic of debate between Robert Shiller of Yale University, Jeremy Siegel of University of Pennsylvania’s Wharton School, and Ben Inker of GMO LLC, as it is written up in today’s Wall Street Journal. Shiller and Siegel became friends since their student years in MIT in the 1970s, yet they disagree on which way the market is going.
Shiller, author of famous book Irrational Exuberance in which he warned of the tech bubble before it burst in 2000, is on the bearish side. His reasons, according to the WSJ:
- Despite the two bear markets, stock have spent almost all their time since 1991 priced above historic average. History suggests that when the stock prices are high, performance in ensuing years is disappointing.
- Shiller compiled market data back to 1881, measuring stock prices month by month relative to corporate profits, To avoid short-term profit distortions, he uses an average of profits over the previous 10 years. Over the long run, by his measure, stocks trade at an average of about 16 times annual corporate profits.
- Today the ratio is about 20. Historically, when stock market hit that number, the average return a decade after that is about -2%, adjusted for inflation
- Catalyst for the bearish scenario could be when the government takes away the support in the housing market. Housing market could be turning down after a brief recovery, which could contribute to a decline in U.S. stocks.
Siegel, also author of a well-read book called “Stocks for the Long Run” is on the bullish side. He contends that Shiller’s method of looking at earnings of the past 10 years doesn’t work well in the current environment due to the large write-offs of the financials in 2008. Instead, he prefers to use the forecasted earning:
- When economy came out of recession, the common P/E is 18.5.
- Currently the market is selling at about 14.5 times forecast 2010 profits, making it cheap in comparison to the past after-recession market.
- If the P/E expand to 18.5, S&P could rise to1400 this year, a 23% gain from today’s level.
- What’s more, ”We could easily see 10% to 12% stock returns with low inflation in future years”, Siegel predicts.
Ben Inker, in consistence of the firm’s stance on the matter, presented his arguments from a different angle – he uses historical profit margins to forecast future corporate profits. His reasoning:
- Internet and real estate bubbles pushed corporate profit margin to 7% above historical level of 6%. The higher margin was due to exceptional borrowing and investment by corporations and consumers.
- While the one percent seems to be small, it represents a 17% jump in profitability which is not sustainable.
- Use the historical 6% margin and applying it to an expected rise in corporate revenues as the economy recovers, he finds that the stocks today trade at almost 19 times expected profits, making them expensive.
- To be reasonably priced, he calculates the S&P 500 would have to fall 21% to about 900.
Of course, true value investors will consider guessing the short-term move of the market is a fool’s game. Whether the market will climb 20% or decline 20% next is really everybody’s guess. Guessing the long-term’s performance might be a fool’s game too, if it is up to guys like Warren Buffett, Bruce Berkowitz, and Donald Yacktman to say. For them, one ought to buy a good business on the assumption that no matter how the market will performance in the next couple of years, the business will do well so will the stock follow.
But at least one can answer question of long term expected investment return of the market with a bit more intelligence.
What to Expect in the Next 8 Years?
GuruFocus has developed a webpage dedicated to answer that question. The theory behind (it is actually explained on the webpage itself, I repeat here in case you do not want to click to another page) is that market return consists of three component: dividend yield, profit growth, and change in market valuation. Quoting from the page:
1. Business growthArmed with this analysis and assuming in 8 years, the TMC/GDP ratio takes any one of the 40% (doom’s day scenario), 80% (average scenario), and 120% (happy ending), one can calculate the expected investment return.
If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.
If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over long term, corporate earnings grow as fast as the economy itself.
2. Dividends
Dividend is an important portion of the investment return. Dividend comes from the cash earning of a business. Everything equal, higher dividend payout ratio, in principle, result in a lower growth rate. Therefore, if a company pays out dividend while with growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.
3. Change in the market valuation
Although the value of a business does not change overnight, stock price does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual business, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.
Putting all the three factors together, the return of an investment can be estimated by the following formula:Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)
As of now, we should expect an average gain of 5.7% for the next 8 years if the market ends the 8-year period at TMC/GDP=80%. Yes, it is mediocre gain as compared to the historical average gain, but it does beat the 10-year treasury yield by about 2%.
Market could sink an average of 2.6% per year if TMC/GD ratio declines to 40%, an extreme level seen in the 1975 to 1985 period. During that period, OPEC was on our case and inflation ran as high as 12%, and long term treasury bonds were yielding at a double digit. Will we go there?
However, if the market participants decides to irrationally exuberant again and TMC/GDP jumps to a 120%, level seen in the 1998-2000 period, we could actually expect a 11.6% gain per annum. What medicine do we need to take in order for us to be so happy again?
So even in long run anything is possible -- if the market goes to the extremes in the next 8 years, the bears like Shiller and Inker could be right, so could be the bullish Jeremy Siegel. Investors are better equipped to know what to expect under each scenario. GuruFocus memebers can access the Broad Market Valuation in real time.
"That's why the value of expertise and the ability to interpret information will someday go to infinity", so says Investment Guru Wilbur Ross recently.
